BOSTON COLLEGE MF808 Financial Policy Case: Clarkson Lumber Company Zachary Ament Jack Duan Bhaskar Edara Daniel NelsonBackground Keith Clarkson, owner and president of Clarkson Lumber Company, has reached the maximum allowable loan ‘amount with Suburban National Bank and is seeking financing options with other banks (Northrup National Bank). Clarkson Lumber has seen sales growth over the past three years of roughly 20% per year; but core problems have led to flat returns, decreasing profitability, and the company's increasing need for cash. Clarkson's problems have been driven by its steady increase in inventory (ex. SSdays in 1998 to 6tdays in 1995) and Customers extending their payment cyoles (Appendix H), As the majority of Ciarkson's sales are repair, not new construction, he is most ikely increasing his range of inventory to capture the diverse needs of the customer. The rising payment cycies of customers can also be attributed to Clarkson's focus on customer service rather than his financial performance. The combination of both events have extended the company's cash gap and increased the need for more borrowing (ex. AVR has been rising at a rate 20% higher than sales growth). The increased borrowing has moved the organization from performance levels among the top 25% to the bottom 25% within the industry (Appendix H). Operational and Financial Considerations In preparing the 1996 financials forthe credit application from Northrup several ratios were found to be consistent in Clarkson's past performance or trending in a direction (Appendix H). Consistent ratios include COGS at roughly 75% of sales, Operating Expenses at 21% of sales, and Gross Profit Margin at 24.25%. Consistency among these factors shows that Clarkson has been able to Keep their operating costs flat with its increase in sales. Unfortunately the trending ratios show a decrease in the overall financial health of the organization; a decrease in liquidity, negative directional movement in cash flows, declining asset management (inventory up, AJR growing, inventory tums increasing, et), problems in debt management, and decining overall performance (profitability). In building the Statement of Cash Flows, Balance Sheet, and Income Statement for 1996 we utiized the ratios calculated on Clarkson's past performance and made judgments based on projected bank requests (e. paying off Holtz in 1996 and paying of Notes Payable - Trade). With the financials complete we evaluated the forgone opportunity of trade discounts. After analyzing both 1995 and Q1 1996 numbers, Clarkson should not take the trade discounts. The trade discounts ‘amount to around $21,000 a year (based on combined accounts payable and trade notes payable of 487 in Q1 1996), waich is less than the $43,800 in addtional borrowing costs incurred if Clarkson extends shortens his payable period from 55 days to 410 days (Appendix !). If Clarkson was to reduce the duration of his accounts payable to 31 days or less, then he could reconsider taking the discounts. However, reducing the payable period by 45 days requires an additional $400,000 in additional borrowing, assumes no operational improvements. This brings total projected borrowing to $956,840 for 1996 (based on Q1 numbers) to finance the cash gap with discounts. This wil consume the entire new $750,000 line of credit and force Clarkson to expand his use of trade notes payable. We do not think Clarkson should take trade discounts as it will aise his leverage to unsafe levels and require him to find additional financing to finance his expansion. Additionally, the bank will likely look unfavorably on or outright prevent Clarkson from drawing down the entire line of credit immediately while not retiring any other debtThe caveat to all these recommendations is that Clarkson's new line of credit from Northrup National Bank has a floating rate of interest. Any decrease in interest rates will make taking the discounts more appealing and any increase less appealing, although holding all other factors equal Clarkson's interest rate could fall to 5% (from 11% currently) before he ‘would consider taking discounts In Qt 1996 Clarkson had a cash gap of 63 days, comprised of 68 days in inventory, 49 days of account receivable ‘and 55 days in accounts payable. Given standard terms of Net 30 days, Clarkson's gains significant funding from his extended ‘accounts payable duration. Stil, that cash gap required $550,000 in additional borrowing in 1995, requiring $60,510 in ‘adkltiona interest expense. Each day reduction inthe cash gap would save about $11,000 in additional borrowing and $1,100 in interest expense. Reducing the cash gap is especially important as Clarkson is highly levered and has recently taken on trade notes payable, a sort of last resort to continue acquiring the necessary raw materials. Even though Clarkson maintains {good relations with his supplier itis unlikely he can grow the duration of is accounts payable much more ‘As Clarkson's business expands the necessary cash and interest expense will increase. In 1994, 1995, and Q1 1996, Clarkson had negative cash from operating and investing activities (Appendix D & G), relying entirely on outside financing to fund the business. For Clarkson to increase sales to $5.5 milion and take all of the trade discounts, Clarkson will need $1,150,000 to finance his cash gap (Appendix |). This is more than double his 1995 cash gap financing. Using the general formula that a business can sustainably grow as fast as its return on equity less dividends, Clarkson can grow at 17-18% a year. Growing sales to $5.5 milion represents 2 22% increase in sales and likely too quick for Clarkson, as witnessed by a projected increase in the 1996 leverage ratio to 3.93 (Appendix H) Recommendations (Our recommended course of action for Clarkson is presented from two different points of view; for this case we will present the point of view of a financial advisor to Clarkson and also a banker at Northrup National Bank. AS the financial advisor we believe the focus for Clarkson should be on improving its performance as outlined in the ratio analysis. Keith Clarkson is clearly motivated to grow sales but doesn't understand the financial implications of his actions. Rather than drive sales growth to $5.5 milion in 1996 we would prefer to see improvements in the company’s Asset Management and Cash Flow ratios. This will improve the bottom line to increase profabilty and sustainabilty. By setting performance goals based on the top 25% of the industry Clarkson will be confident sales increases will result in incremental Net Ineome rather than incremental borrowing cost. As a banker at Northrup our focus would be on protecting out investment, and in the case of Clarkson that would include a lengthy lst of covenants (Appendix J). We would approve the loan as Clarkson is performing well and we do not have any specific interest in running the organization but rather ensuring that our customers can service their debt. Establishing covenants allows us to control specific items without directly controling the firm. 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Ratio Analvsis ‘Comp Data Entered if Available 1993 1994 1995 1996 Projected) |ndustry-Bottorn 25% Industry - Top 25% Liquidity Current ratio as) = seg 115 13 aa 252 Quick ratio 1270 Gt 06s (cash Flow Ratios Operating Cash Flow 0.06% -177% 27% Cap Ex Coverage 0.76% 20.62% — -3851% Current Debt Coverage 0.35% 7.35% 129% Total Debt Coverage 0.2K 673K 10.64% Operating Ratios Gross Profit Margin 261% 24.25% 24.23% 25.00% Operating Exepnse/Sales 21.29% 70.62% 20.80% 21.00% Operating Profit Margin 3.32% | 3.62% 3.43% 5.09% Net Profit Margin " 205% " 196% " 170% 173K Return on Sales 332% 3.62% 3.43% 4.00% 0.70% 4.30% Return on Equity 11.90% 18.28% 17.15% 19.79% “14.30% 22.10% Return on Assets 653% 5.88% 4.70% 5.04% 1.8036 12.20% ‘Asset Management AJR Turnover 955 8a 7.86 6.66 Days Receivable Outstanding 37.71 2.55. 48.28 5082 Inventory Turnover 653 6105.83 66 Days in inventory 5586 S986 C257 55.3 Fixed Asset Tumover ms¢ 1327-1165 14.18 Total Asset Turnover aia | aol ! 276 292 Debt Management. Debt/Eculty os. 211265 293 TTL 22.0 a7 138 134 Days Payable Outstanding 3531 anil 5362 4037 DuPont Analysis Profitability 2.05% 1.95% 1.7036 173% ‘Asset Utilzation 318 301276 292 Leverage Multiplier gz an 365 3.93, Industry Comps Percet of Sales cogs 75.39% SISK TST 75.00% 720% 75.3% Operatingexpense 21.29% 20.62% 20.80% 21.00% 220% 20.68% Cash 147% 150% 1.28% 0.859% 13% 11% AR 10.48% 11.82% 13.41% «= 15.02% 13.7% aw Inventory 150% 12.42% 12.99% 11.33% 32.0% 116% Fixed assets 7.98% 7.58% 859% 7.05% mi% 98.2% Total Assets 31.46% 33.28% 36.22% 34.25% 39.1% 30.3% Percent of Fatal Assets Current abilities 29.92% 48.83% 66.46% 70.2896, 52.7% 29.2% Long-termLiabilities 15.23% 19.01% 6.11% 425% 34.8% 16.0% Equity SAM 3215% 27.43% 25.48% 25% 56.8%All numbers in 00's Trade Discount Cost of Borrowing, Gross Margin Daily COGS Payable Days with Discount Accounts Payable Days Inventory Days Accounts Receivable Days Cash Gap Cash Gap (with discounts) Without Discounts Required Borrowing Cost With Discounts Required Borrowing, Cost Addi Addi ial Borrowing al Cost Accounts Payable Notes Payable, Trade Total AP Sales Discount Savings Q1 1996 % 1% 24.76% 8.88 10 55 68 49 6 108 Qi 1996 558.62 61.45 956.84 105.25 398.22 43.80 364 123 487 1,062 21.04 22.16 Appendix | 1995 % 11% 24.23% 938 10 53 6B 49 59 102 1995 530.05 60.51 992.35 104.76 402.30 44,25 376 127 4519 219 22.35 1996 Projected Hypothetical % 2% 11% 11% 24.76% 24.16% 5500 10 10 10 31 6 68 49 49 lo2 87 102 108 Qt 1996 TAI 84.75 1,150.93, 956.84 126.60 105.25 186.43 20.51 364 123 487 1062 21.04 0.53 24.76% 10 55 30) 25 45 Q1 1996 0.00 0.00 399.50 43.95 399.50 43.95 364 123 487 1062 21.04 22.91 2% 5% 24.76% 10 35 68 49 63 108 QI 1996 958.62 27.93 956.84 47.84 398.22 19.91 364 123 1,062 21.04 113‘Appendix J Northrup National Bank - Suggested Covenants 41) Use new Line of Credit to pay off trade notes payable. This assumes that notes payable trade is more costly than the floating rate on the LOC and Ciarkson should take this opportunity to replace higher debt with lower. 2) Clarkson's receivables conversion period will not exceed 55 days. Clarkson's receivables are trending higher each year and he needs to improve his collection time to improve margins and reduce his borrowing needs 3) No other borrowings or debt issuance without Northrup National Bank approval 4) No issuance of dividends without Northrup National Bank approval 5) Clarkson must payable make the Holtz payment in full and on time.